We have an awesome CEO list that covers plenty of topics. Early in the week I posted a link to Fred Wilson’s post Buying Your Holiday Gifts With Bitcoin. That generated a fun discussion including lots of “what are bitcoins and why do I care”; “here’s what they are” kind of things. And then Kwin Kramer of Oblong weighed in with a phenomenal essay. It follows.

I’m with Seth; I think bitcoin is interesting on several levels, including as a real-life experiment with a semi-decentralized currency.

Bitcoin is a software engineer’s implementation of money (as distinct from, for example, a politician’s, banker’s, or economist’s).

There’s a lot of overlap between bitcoin fans and folks with strongly libertarian views. Many of bitcoin’s most vocal proponents see bitcoin as a currency, a replacement for currencies that are created and managed by governments. These folks tend to view bitcoin as a sort of electronic version of gold, a new currency that’s not a “fiat” currency.

I’m deeply skeptical of this set of ideas. First, and very generally, I don’t tend to think that dis-intermediating government institutions is a useful goal in and of itself. I would describe a well-run central bank like the United States Federal Reserve the way Churchill described democracy: the worst solution to the problem of managing a monetary system, except for all those other forms that have been tried from time to time.

In addition, core design decisions in the bitcoin spec make bitcoin a pretty terrible store of value and unit of account, which are two things we expect from a currency.

As has been noted in this thread, the total number of bitcoins is capped at 21,000,000. Currently there are about half that number of bitcoins in circulation. The rate at which new bitcoins are mined is designed to decrease over time. This means the bitcoin market behaves more like a commodity market than like a currency market, prone to volatility and some specific kinds of market pathologies. In my view the fact that the money supply can’t be “managed” by a central bank that is able to turn various “knobs” (interest rates of several kinds, the amount of money in circulation) is a bug, not feature!

The cap also means that a bitcoin-denominated monetary system will be a system built around deflation — the opposite of how the monetary system we use today is constructed. Over time, prices will fall, rather than rise. Economists generally view deflation as a problem. If prices get cheaper over time, all the time, people have strong incentives to delay purchases and to save money. If everyone saves, rather than spends, economic growth is impossible.

Economists have lots of tools for talking about this stuff. And, while economists often disagree violently with each other, the collective knowledge in the field is important and valuable. To draw an analogy, non-programmers can and often do have very insightful things to say about digital technology. But it’s definitely worth talking to experienced programmers when trying to understand a particular platform, protocol, or application.

I’m not an economist, but I find convincing the economists’ consensus that deflation is “bad.” At the very least, I’d argue that we don’t know how to build a stable monetary system on top of a currency that is fundamentally deflationary.

On the other hand, even if bitcoin makes for a poor currency, it may well be a very useful payment mechanism. The original bitcoin paper focuses heavily on this aspect of the system design.

To explain this a little more, we can think about how we use US dollars in normal, every-day life. I usually keep some printed dollar banknotes in my pockets. These banknotes — these “dollars” — are a store of value. (They’re worth something in an economic sense.) The banknotes are also a unit of account. (Lots and lots of things I encounter every day have prices denominated in dollars.) Finally, each banknote is a payment mechanism — a transaction mechanism. I can hand over a banknote to most people I might want to buy something from. They’ll accept it. We’ll both know what that means.

But physically handing over a “dollar” isn’t the only payment mechanism I regularly use. I have credit cards, and checks (sort of — that’s kind of changing), and now some other electronic payment mechanisms like PayPal and Amazon points.

It’s possible to separate the functions of value store, unit of account, and transaction mechanism. They fit together neatly and are systemically related, but they’re three different things.

Which boils down to a way to “hand someone cash” electronically. With no trusted third party having to broker the handover. And, theoretically, anonymity for both the payer and the payee.

As a software person, I think of this as a platform. A new electronic payment platform that may have significant advantages over most of the existing ones. To get broad adoption, platforms need killer apps. So far, there aren’t killer apps for bitcoin. But there are some possible raw materials for killer apps. Cheaper international payments. Completely anonymous electronic payments. But the great thing about platforms is that it’s often quite hard to predict early on what the killer apps might be. Particularly for the really disruptive ones.

A couple of final caveats. It’s not clear (at least to me) whether it’s possible to separate the currency aspects of bitcoin from the transaction platform aspects. If bitcoin does turn out to be a flawed currency, that could be a problem even if the transaction platform stuff is really useful.

Also, the bitcoin platform is pretty new and there may be some fatal flaws in the design of its anonymity features and its transaction log. For example, the transaction log is a global, permanent thing. To verify any bitcoin transaction you have to have a full record of every bitcoin transaction ever. That’s okay now; the system is small. Our computers and networks will keep getting faster as bitcoin use increases. But a broadly used currency will have to be able to support a lot of transactions. Maybe the design can be patched, either in a technical sense or in a social/institutional sense. But we don’t really know.